How Smart is "Smart Beta"? By: Bradford L. Long, CFA, Senior Research Analyst
Once an investor has established his or her asset allocation, a challenging task in itself, he or she is subsequently faced with portfolio implementation. On one end of the implementation spectrum are passive market capitalization weighted indices. These investments seek to replicate the risk and return of a specified market at the lowest cost possible. At the opposite end of this spectrum is an active investment that seeks to use a myriad of approaches to produce returns above that of the index. Active investing inevitably comes at a higher cost than passive investing given the additional research required to outperform the index. On this continuum of active and passive investing, smart beta lives somewhere in between. Smart beta refers loosely to portfolios that employ an alternative process to market capitalization weighting investments. Their intuitive appeal is combining the best parts of both passive (low cost and individual stock risk) and active investing (outperforming the index) into one portfolio. The manner in which smart beta portfolios seek to achieve these objectives varies, but they generally have the following characteristics in common:
1. Quantitatively managed and implemented
2. Liquid markets and simplicity of investment thesis
3. Factor tilts that have intuitive or empirical support
The first two characteristics are almost ubiquitous among smart beta portfolios. These help produce portfolios that are scalable and therefore keep costs low. The third characteristic, however, varies considerably among smart beta strategies and can materially change the anticipated risk and return expectations for the investor.
Factor tilts are not new to investing. The concept predates the term smart beta and is often found in both active quantitative and fundamental investing styles. The active investor is being judged on how their portfolio performs relative to the index. Intuitively, to outperform the index, the complexion of the portfolio has to deviate from that of the index. We have written about this concept in past articles (see active share). How the portfolio differs from the index is crucial because these differences will dictate the relative performance compared to the index. Great efforts in academia and the investment industry have been undertaken to understand future price performance. One could argue that the basis for all investing is rooted in factor tilting. For example, Benjamin Graham’s The Intelligent Investor, first published in 1949, is often viewed as a manual for purchasing value stocks (stocks whose price is inexpensive relative to peers). This theory is often translated to smart beta by factor tilting toward companies with a lower price-to-earnings or price-to-book to capture the value premium. Factor tilting is not exclusive to value investing either. Momentum, low-volatility and quality all provide examples of additional factor tilts frequently used in smart beta portfolios.
So how smart is smart beta? In some ways, smart beta truly does combine some of the best aspects of active and passive investing. However, this is a cautionary tale. As is often the case, the devil is in the details. The factor tilts serve as the primary driver of the risk and return experienced by the investor. Additionally, much like active investing, smart beta will exhibit cyclicality in its success relative to the index. Even factors that are successful over the long-term will have periods in which they are out of favor.
The primary disadvantage with smart beta is how smart it can become. The business model of smart beta investments is designed for scalability and low cost relative to active investing. In other words, the model to implement factors tilts has to be relatively simple and systematic and can only traffic in liquid markets. When these models are compared to their smarter and more expensive counterpart, quantitative active investing, the IQ of smart beta does not compete. This limitation prevents smart beta from accessing many of the techniques that quantitative managers have been using for years to take advantage of market anomalies. Overall, “smart beta” can be a strong solution for some clients, but viewing all of these portfolios as homogenous to each other can be problematic. Investors that utilize these portfolios should give additional consideration to the impact a smart beta investment will have on their total portfolio. Given that a factor tilt will be pronounced in these portfolios, this may open the portfolio up to style implications that can affect future returns and risk.
For further information and assistance with evaluating smart beta and other investment products, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
